Question

Crown Co. is expecting to receive 100,000 British pounds in one year. Crown expects the spot rate of the British pound to be $1.49 in a year, so it decides to avoid exchange rate risk by hedging its receivables. The spot rate of the pound is quoted at $1.51. The strike price of put and call options are $1.54 and $1.53, respectively. The premium on both options is $.03. The one-year forward rate exhibits a 2.65 percent premium. Assume there are no transaction costs. What is the best possible hedging strategy and how many U.S. dollars Crown Co. will receive under this strategy?

Answer 1

The best possible hedging strategy for Crown Co. is to buy a put option with a strike price of $1.54. They will receive $151,000 under this strategy.

Step-by-step explanation:

The best possible hedging strategy for Crown Co. in this scenario would be to buy a put option with a strike price of $1.54. This put option will allow Crown Co. to sell 100,000 British pounds at $1.54, protecting them from a potential decline in the pound's value. The premium on the put option is $0.03, so the total cost of the put option would be $0.03 ×100,000 pounds = $3,000.

If the spot rate of the pound in one year is $1.49, Crown Co. can exercise the put option and sell the 100,000 pounds for 100,000 ×$1.54 = $154,000. However, since they paid a premium of $3,000 for the put option, the net amount they will receive is $154,000 - $3,000 = $151,000.

Answer 2

Sell pound forward

Step-by-step explanation:

Forward rate = $1.51 *(1+2.65%) = 1.51 * 1.0265 = 1.55

Amount receivable in case of forward hedge = 100,000 * 1.55 = 155,000

Premium payable on put options = 100,000 * 0.3 = 3,000

Amount receivable in put options = 100,000 * 1.54 = 154,000

Net receivables in put options = 154,000 - 3,000 = 151,000

Conclusion: Higher amount is available in case of forward hedge. So, sell pound forward